Too hot to handle

India cracks down after a stockmarket and rupee rally

WHEN the world's equity investors rediscovered their appetite for risk after the Federal Reserve cut interest rates on September 18th, they took a particular liking to anything curry-flavoured. In less than a month, India's benchmark Sensex index climbed by more than 20%, and on October 15th it hit yet another a new record. The inflows of capital pushed the rupee to its highest level in more than nine years.

That was enough for India's cautious regulators, who fear that speculative money from abroad may interfere with efforts to cool the country's sizzling economy. After the market closed on October 16th, the securities regulator unveiled rules it proposes for foreign investors who are not registered in India. The news hit sentiment like a bucket of cold water; on October 17th the stockmarket slumped by more than 9% in a few minutes, leading to a one-hour trading suspension. The rupee also tumbled. (The index pared back its losses after some soothing words from government officials, closing down 1.8%.)

India's financial authorities are particularly concerned about a problem that has caught the attention of their peers elsewhere in Asia: the difficulty they have in keeping track of the more opaque inflows of money. Foreigners have invested close to $18 billion in Indian shares this year, more than half of which is estimated to have been in the form of derivatives, known as participatory notes. These are sold to offshore investors by approved institutions. They allow the buyers such as hedge funds to gain exposure to Indian stocks without acquiring the actual securities and without registering with the Securities and Exchange Board of India (SEBI). In more than three years, the number of institutions issuing the notes has risen from 14 to 34, and the notes' face value has risen more than tenfold to 3.5 trillion rupees ($88 billion).

SEBI's proposal (it intends to make a final decision on October 25th) is to stop the issue of new participatory notes based on equity derivatives, and to wind down outstanding positions over the next 18 months. About one-third of the notes are linked to equity derivatives. The proposal also aims to limit notes based on actual shares.

Palaniappan Chidambaram, the finance minister, said that the proposed rules were aimed at moderating “copious” capital inflows. Meleveetil Damodaran, SEBI's chairman, suggested they were also intended to improve transparency. He invited foreign investors to come in “through the front door.” The notes have long been controversial but the government's actions this week should have taught some important lessons to all concerned: first, that investing in India is not an open goal; and second, that playing with capital controls—even on the market's murky edges—can be a dangerous game.